The Evolution of the CMBS Market

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The Evolution of the CMBS Market

• CRE Annual Convention Maui, HI
• October 23-26, 2006

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I. Historical Overview
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Historical Overview - CMBS

• First recorded CMBS transaction 1985
• CMBS prominence grew following RTC transactions
  in the early 1990s
• SL crisis in early 90s RTC formed to liquidate
  assets
• Liquidity shortage Wall Street steps in to pool
  performing and non- performing loans
• In 1995, total CRE loans outstanding was 1.014T
  and CMBS represented 5.4.
• In 2005, total CRE loans outstanding was 2.618T
  and CMBS represented 19.9. CMBS represented
  37 of all CRE loans originated in 2005 (460B).
• Types of transactions conduit, fusion, single
  borrower / asset, floating rate, agency.
  Conduit and fusion made up approximately 72.7
  of all CMBS transactions in the US in 2005.

Source Commercial Mortgage Alert, Wachovia
Securities and Mortgage Bankers Association
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Historical Overview - CMBS
Source Commercial Mortgage Alert
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Historical Overview - CMBS

• Investors B-piece buyers and Investment grade
• B-piece buyer CRE savvy first loss position
• Investment grade Institutional investors,
  insurance companies, money managers, pension
  funds, banks
• Typically, European investors are more focused on
  floating rate transactions / bond classes and US
  investors purchase more fixed rate product
• Short duration match assets to funding sources
• Utilize currency hedges and would rather not put
  on interest rate swaps in addition to currency
  hedges
• Delinquency performance over the last 10 years
  has been strong with a current delinquency rate
  across all CMBS deals of 0.51.
• Reasons for low delinquencies despite higher IR
  and market fundamentals being weaker
• Strong capital flows
• Borrowers willingness to accept lower cap rates

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Historical Overview - CMBS
Source Lehman Brothers Lehman Live
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Historical Overview - CMBS
Source Lehman Brothers Lehman Live
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Historical Overview - CDO

• Re-REMICs and CDOs have been utilized for the
  past 10 years on corporate bonds.
• CRE Re-REMICs were first utilized in the mid
  1990s
• The first CRE CDO was in 2001. Since 2001, CRE
  CDO and other CDO products (synthetics) have
  exploded with popularity and have heavily
  impacted credit in the CRE origination market.
• Re-REMIC v CDO
• Re-REMIC tax efficient structure, REMIC bonds
  only, static structure, US issuer only, very
  inflexible
• CDO all types of collateral permitted, off shore
  issuer, static or managed pool, ramp allowed,
  reinvestment allowed, call options allowed, very
  flexible

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Historical Overview - CDO
Source Commercial Mortgage Alert
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II. CMBS Process
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CMBS Process

• CMBS loan versus a portfolio loan
• Pricing versus flexibility
• Overview of CMBS Process
• Originate commercial mortgage loans on
  properties typically non-recourse lending
• Accumulate a pool of loans
• Present pool to rating agencies to obtain bond
  structure
• Present pool to B-piece investors for bid and
  select B-piece investor for due diligence
• Finalize pool with B-piece investor and rating
  agencies and circulate prospectus to investors
• Sell investment grade bonds
• Contributors include commercial banks,
  investment banks, insurance companies, finance
  companies

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CMBS Process

• Contributors team up to
• Grow the size of the deal
• Enhance market liquidity
• Serve as market benchmarks
• Increase turn over velocity to increase ROE.
• Prepayment risk reduced with YM and defeasance.
• Benefits to Issuer
• Move loans off balance sheet and free up capital
• Increase ROE by selling loans on a regular basis
• Provide another loan product to meet clients needs

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CMBS Process

• Challenges in todays market
• Lack of amortization
• Lack of structuring
• Increased leverage
• Return of esoteric property types
• Increased loans in tertiary markets
• Single tenant loans
• Increased hospitality concentrations
• TICS and DST borrower structures
• Cap rate and interest rate disconnect
• Believe in the upside story

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III. CDO Process
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CDO Process

• Overview of CRE CDO Process
• Originate or acquire various types of collateral
• CMBS bonds, mezzanine debt, B-notes, whole loans,
  synthetics
• Accumulate collateral to meet specific / desired
  diversification targets
• Present pool to rating agencies to obtain bond
  structure
• Static versus managed pool
• Pools are static or managed, with or without ramp
  periods and reinvestment allowed
• Negotiate with rating agencies to obtain the
  desired coverage test requirements
• Determine the asset manager normally the issuer
• Sell investment grade bonds, issuer usually
  retains the equity piece
• Contributors include commercial banks,
  investment banks, insurance companies, finance
  companies, REITs, etc.

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CDO Process

• Investors of CDOs include financial
  institutions, insurance companies, money
  managers and others
• Through 2005, there were over 100 institutional
  investors in the US and abroad
• 55 of investors are domestic and 45 are
  overseas primarily UK and Germany
• Benefits of CDOs
• Match term funding
• No mark-to-market risk
• Cheaper source of financing
• Increase assets under management and fees

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CDO Process

• Other attributes of CDOs
• Motivation typically either
• Assets Under Management (AUM) - fee driven
  motivation, lower credit leverage collateral
  assets, sell portion of the preferred shares.
  Typically done by Money Managers.
• Financing seek match term funding, non-market
  to market (alternative to repo), retain preferred
  shares.
• Issuers are typically RE Funds, Mortgage REITs,
  and B-piece buyers.
• All collateral assets are rated or shadow rated
• Generally limited to current pay assets

Source Wachovia Securities
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CDO Process

• Capital structure determined by rating
  agencyexpected default and recovery values on
  collateral
• Typical leverage of 20-25x for AUM deals, 3-10x
  for Financings
• Other issues on or off balance sheet, QSPE or
  SPE may impact ability to manage

Source Wachovia Securities
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CDO v CMBS

• CDO
• Issuer Cayman Island Trust
• Able to hold non-mortgage assets
• Unsecured debt (e.g. REIT debt)
• Mezz, Preferred Equity
• Derivatives (e.g., swaps, caps, CDS)
• Able to issue classes as fixed or floating
• First, second or multiple re-securitization of
  assets
• Offers manager flexibility (e.g., static vs.
  managed, mixed sector, ability to take views on
  credit), may or may not be fully ramped at
  closing
• Collateral quality tests (if managed)
• Excess spread goes to equity
• Structural protections
• Subordination
• OC and IC Triggers (no principal write-downs)
• Collateral quality tests
• Offers ongoing management fees
• Global buyer base
• First loss class
• Excess cash flow class

• CMBS
• Issuer Real Estate Mortgage Investment Conduit
  (REMIC)
• Trust required to hold only mortgage loans
• No unsecured debt
• No derivatives contracts, no substitution of
  assets
• Generally issues debt of similar basis as assets
  (e.g., fixed fixed floating floating)
• First securitization of asset
• Static pools only, 100 ramped at closing, no
  manager involvement post closing
• Excess spread sold as Interest Only (IO) Bond
• Structural protections
• Only subordination (principal write-downs)
• No ongoing management fees
• Primarily domestic buyer base (fixed rate)
• First loss class
• Fixed coupon
• Principal write-downs via
• Appraisal reductions
• Realized losses
• Cash flow shuts off permanently upon 100
  write-down.

Source Wachovia Securities
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IV. Future of CMBS CDO
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Future of CMBS CDO

• CMBS FASB issues
• Liquidity
• Origination
• Investments
• CDO replacing CMBS?
• Synthetic CDOs
• Continued growth
• United States / Canada
• Europe
• Stock market

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V. Questions Answers